Back-to-back lease arrangements are becoming increasingly prevalent in real estate-driven business models across the Kingdom of Saudi Arabia. Commercially, the model appears straightforward — a company leases an asset and subleases it to generate a spread. Accounting-wise, however, IFRS 16 introduces a layer of complexity that many organisations underestimate.

In a representative structure, an entity entered into a head lease for land (1 October 2025 – 31 December 2031) covering 22 instalments of SAR 550,000 each (excluding VAT), then subleased the same land for substantially the same term at total contractual inflows of SAR 29.6 million (excluding VAT).

Applying a supportable incremental borrowing rate (IBR) of 8.21%, the accounting outcome was as follows:

The pivotal technical takeaway: sub-lease classification under IFRS 16 must be assessed with reference to the right-of-use (ROU) asset — not the underlying land. This single distinction routinely changes an arrangement from a simple rental model to finance lease accounting.

What IFRS 16 Requires — and How It Applies in Practice

A technically sound analysis cannot rely on general principles alone. Each requirement of IFRS 16 must be applied directly to the facts of the arrangement.

1. Lease Identification (IFRS 16.9)

A contract contains a lease when it conveys: the right to control an identified asset, for a period of time, in exchange for consideration.

In this case, the land is explicitly identified in both contracts, the lease term is contractually defined at 6.25 years, and the entity holds the right to sublease, derive economic benefits, and direct use.

Conclusion: Both the head lease and the sub-lease fall within the scope of IFRS 16.

2. Recognition Exemptions (IFRS 16.5)

Neither the short-term exemption nor the low-value exemption applies here. The lease term exceeds 12 months, the underlying asset is land (not low value), and the existence of a sub-lease arrangement explicitly precludes the low-value exemption.

3. Lease Term (IFRS 16.18–19)

Lease term encompasses the non-cancellable period plus any extension periods only where exercise is reasonably certain. Although the contracts contain renewal clauses, there is no demonstrable economic incentive to extend beyond the sub-lease term.

Conclusion: The lease term is restricted to the non-cancellable period (1 October 2025 to 31 December 2031). Extension options are not considered reasonably certain.

4. Discount Rate — Incremental Borrowing Rate (IFRS 16.26)

Where the implicit rate in the lease cannot be readily determined, IFRS 16 requires use of the lessee’s incremental borrowing rate (IBR). In this structure, private equity funding rates were appropriately rejected as a benchmark.

A market-based approach was applied instead: SAIBOR base rate plus an appropriate market spread, reflecting secured borrowing economics for a comparable term and environment.

Conclusion: The IBR must reflect secured borrowing economics, not investor return expectations. The selected rate of 8.21% is consistent with IFRS 16 requirements.

5. Lease Payments (IFRS 16.27)

Lease payments include fixed amounts but exclude VAT (where recoverable) and non-lease components. In this case, 22 instalments of SAR 550,000 were included, and VAT was correctly excluded from the calculation.

6. Initial Measurement

7. Sub-Lease Classification — The Critical Judgement (IFRS 16.B58)

This is the most consequential requirement in back-to-back structures. IFRS 16.B58 is explicit: sub-lease classification must be assessed based on the ROU asset, not the underlying asset.

The practical impact of this distinction is significant:

• If assessed against the land: land has an indefinite useful life, which would typically indicate an operating lease — an incorrect conclusion under the standard.
• If assessed against the ROU asset: the sub-lease term covers substantially all of the remaining economic life of the ROU asset, and rights are substantially transferred to the sub-lessee.

Conclusion: The sub-lease is classified as a finance lease.

Numerical Overview

Head Lease

Sub-Lease

Note: The net investment represents the present value of sub-lease payments discounted at an appropriate rate, consistent with IFRS 16 lessor accounting principles.

Initial Accounting Impact

Financial Statement Impact

Balance Sheet

• Lease liability is retained as a financial obligation
• ROU asset is derecognised upon sub-lease commencement
• Lease receivable is recognised as a financial asset
• Net investment in sub-lease is presented as a long-term receivable

Profit or Loss

• Day 1 gain is recognised at commencement of the sub-lease
• Finance income is recognised progressively over the sub-lease term
• Interest expense on the head lease liability is recognised separately

Commercial vs. Accounting View

Key Risk Areas — Audit Focus

In our experience reviewing back-to-back structures, the following errors appear with notable frequency:

• Sub-lease misclassification: Assessing classification against the underlying land rather than the ROU asset, incorrectly defaulting to an operating lease.
• Incorrect IBR: Using WACC or private equity return rates, which do not reflect the borrowing economics required under IFRS 16.
• VAT in lease liability: Including VAT amounts in the lease liability calculation without proper recoverability assessment.
• Incorrect lease term: Automatically extending the lease term to include renewal options without demonstrating that exercise is reasonably certain.
• Ignoring back-to-back alignment: Failing to consider the interplay between head lease and sub-lease terms in the classification analysis.

CFO Insights

Structuring decisions made at the commercial level directly influence accounting outcomes. Finance leaders should be aware that what appears to be a straightforward lease spread model may, under IFRS 16, constitute a financing arrangement with materially different reporting implications.

Finance Lease Classification Affects:

• EBITDA — finance income replaces rental income, altering EBITDA presentation
• Revenue profile — front-loading of Day 1 gain versus straight-line rental income
• Asset base — lease receivable replaces ROU asset on the balance sheet
• Audit scrutiny — finance lease judgments are subject to heightened review

Documentation Requirements

• IBR memo: documenting the methodology and inputs used to derive the incremental borrowing rate
• Lease classification memo: supporting the finance vs. operating lease conclusion for the sub-lease
• Cash flow models: demonstrating the split of inflows between principal recovery and interest income

Misclassification in this area can lead to material misstatement in both revenue recognition and asset presentation — two areas of heightened focus in financial statement audits.

Conclusion

Back-to-back land sub-lease structures are commercially attractive but technically demanding under IFRS 16. The framework is clear: sub-lease classification must be evaluated against the ROU asset, not the underlying land.

Where the sub-lease term aligns with the head lease and substantially all economic benefits are transferred, finance lease classification will typically follow — resulting in recognition of a net investment in lease, a transition to the finance income model, and significant balance sheet reclassification.

Entities entering into such arrangements should engage with a qualified technical accounting advisor early in the process to ensure the accounting treatment is correctly identified, documented, and disclosed.